Remember the IRS threshold that distinguishes a sometimes-rented vacation home from an investment property? If you rent your property out, you need to occupy it for at least 14 days during the year or at least 10% of the number of days you rent it out. If you do, you can treat the vacation home as a secondary residence for tax purposes. If not, the IRS considers it an investment property. That's regardless of whether you primarily bought it for investment purposes.
Let’s start with the common implications. No matter how a rented property is classified, you must report rental income on your tax return. You can also deduct certain expenses from it. Imagine that you earned $5,000 of rental income last year and spent $2,000 on maintaining and repairing the property. In this case, you'd have $3,000 in taxable rental income.
Here’s the important part. If the IRS considers your vacation home an investment property, you can’t use the mortgage interest or property tax deductions. You can, however, deduct those from your taxable rental income and use the investment property depreciation deduction. That can have a big impact on your tax liability. In fact, many profitable investment properties show a loss for tax purposes because of the valuable tax benefits available to them.
We’ll get into financing vacation homes in a bit. Just remember that it can be much more difficult and expensive to finance an investment property than a home you intend to occupy (even if you rent it out).
If you only rent your vacation home out every once in a while...
The IRS has a special rule for properties that aren’t rented very often. If you rent your vacation home out for 14 days or less each year, you don’t have to report that rental income or pay any taxes on it. Even if you rent your home out and make thousands of dollars in those two weeks, the IRS can’t touch a penny.
Just something to keep in mind.
Are you allowed to rent your vacation home out?
Another question to answer before you make an offer is whether you’re even allowed to rent the home out.
Many vacation destinations have restrictions on rentals. For example, I used to live in Key West, Florida. Rentals for less than a month at a time are prohibited by the city unless you get a very expensive “transient license” for the property.
Some condominiums or homeowners associations (HOAs) also have restrictions on rentals. One condo I looked at prohibits rentals until you’ve owned the property for at least a year. This discourages people from buying units purely for investment purposes. Others don’t allow short-term rentals at all. And "short-term rental" has a variety of potential definitions.
If you’re planning to rent your vacation home out, or relying on being able to rent it so you can afford it, make sure that you’re allowed to. In many places, the fines for illegally renting a property are quite severe and enforcement efforts are widespread. Don’t think you can just rent it anyway. A local real estate agent should be able to help you figure out if a particular property is rentable and what restrictions exist.
How much does it cost to hire a property manager for a vacation home?
Another thing to think about before renting your vacation home is whether you want to self-manage or hire a property manager. It can be extremely difficult, if not impossible, to manage a vacation rental yourself if you don’t live nearby. There’s too much that needs to be coordinated in person. You'll need to make sure the property is cleaned between renters and be nearby to deal with lockouts and maintenance problems.
The problem with hiring a property manager is that it’s expensive. For long-term rental properties, the industry standard property management fee is 10% of the rental income collected. With vacation rentals, the standard fee jumps to 25–30% of the rent. That’s a lot of money. If your beach condo brings in $1,500 per week, you could pay your property manager more than $5,000 during a three-month busy season.
Why so expensive? Because managing a vacation rental is much more time-consuming than managing a long-term rental. Think about it this way. If you buy a duplex as a rental property, your property manager has to find a tenant, have them agree to a year-long lease, and deal with the occasional maintenance issue. With a vacation rental, the manager needs to market the property constantly, coordinate regular cleanings and maintenance, and deal with vacationers’ problems.
Hiring a property manager to oversee your vacation home rental is a big expense. But many owners find it well worth the cost. Plus, if your manager can market the property more effectively than you can, the resulting increase in occupancy and average rates can help offset the fee.
How do you finance a vacation home?
The most well-known types of mortgages are for primary homes and investment properties. However, there's a third option that sits between the two. They're typically called “second home” mortgages.